Daily Archives: August 16, 2011

This is the third part in a series discussing financial regulation. Sheila Bair, FDIC Chair, has justly reserved praise for her service. Her willingness to support meaningful regulation distressed the Obama administration (and would have enraged the Bush administration). Without in any way diminishing her accomplishments it is important to understand that regulation has become so pathetic that Bair’s actions seem to be the zenith of regulatory vigor. We live in a time when even progressives have given up on regulation. Effective financial regulation is not only possible but essential if we are to avoid suffering recurrent, intensifying financial crises. We need to insist that regardless of the party in power the financial regulatory professionals are supported in accomplishing their prime mission – serving as the regulatory “cops on the beat.” Only regulatory cops on the beat can break the “Gresham’s dynamic” that accounting control fraud causes that can produce fraud epidemics, hyper-inflate bubbles, and cause financial crises. This installment shows how vigorous and effective regulation can be.

My first two installments explained how Federal Home Loan Bank Board Chairman Ed Gray reregulated the S&L industry over near total opposition and saved the nation $1 trillion by preventing a financial crisis. Gray realized that the central problem had become frauds led by CEOs (what we now call “control fraud”). He made the agency’s two top priorities the closure of the control frauds and their prosecution. Under Gray, the agency created a formal criminal referral process and hired top supervisors with a reputation for courage, competence, and vigor to attaining those priorities.

The Reagan administration’s cynical secret deal with Speaker of the House Jim Wright to not reappoint Gray as Chairman when his term ended on June 30, 1987 led to the appointment of M. Danny Wall (Senator Garn’s top aide). Wall had, as Garn’s aide, advised Gray to give in to Wright’s “request” that we fire our most prestigious and important supervisor, Joe Selby. Gray had personally recruited Selby to supervise Texas S&Ls, the largest hunting ground of the control frauds. Wall immediately sought to reverse many of Gray’s policies. He publicly took “credit” for forcing Selby to resign. He removed our (the Federal Home Loan Bank of San Francisco’s (FHLBSF) jurisdiction over Lincoln Savings because we continued to insist that it should be taken over. Wall was terrified by Charles Keating’s political power, which included the five U.S. Senators that became known as the “Keating Five” after they unsuccessfully sought to intimate us at the April 9, 1987 meeting, and Wright. Wall’s staff refused to forward our referrals to the enforcement agencies against the largest S&L in the nation. He stated that, “by definition,” we did not place Texas S&Ls in receivership, and he took credit for reducing the number of enforcement actions. Wall’s self-description was that he was a “child of the Senate” and his actions demonstrated the accuracy of his admission.

Enforcement had long been the Bank Board’s weakest link. I referred to it as “the land of the invertebrates.” Left to its own devices, it had always been a serious barrier to regulatory effectiveness. How bad was it – the lawyers representing fraudulent S&Ls actively sought to get our enforcement lawyers in the room when discussing supervisory problems. Our enforcement director was so clueless that she thought this was a good thing.

When the first President Bush took office he faced a dilemma in determining the regulatory response to the S&L debacle. As Reagan’s Vice President, Bush Chaired the administration’s financial deregulation task force. He was, therefore, as culpable as anyone in the nation for the deregulation and desupervision that made the S&L industry a criminogenic environment. We now know from document obtained through discovery from Lincoln Savings that Keating’s lobbyists viewed VP Bush’s offices as containing strong supporters of Keating and Gray’s fiercest critics. Bush also owed Wall a large political debt. Wall’s nickname on the Hill was “M. Danny Isuzu.” (Isuzu was running commercials then featuring a car salesman who was an obvious, inveterate liar.) The central lie that Wall was spreading in 1988 in the run-up to the election was that there was no S&L crisis and no need for federal funds. This lie was of significant benefit to Bush’s candidacy.

Bush also knew, however, that Wall was a disaster. Bush’s response to the dilemma was politically astute. He immediately ordered that the Bank Board would no longer run any receiverships but would instead appoint the FDIC as its receiver for any new failed S&Ls. He framed the FIRREA bill that terminated FSLIC and transferred the S&L insurance function to the FDIC. Both of these actions enraged Wall. The FIRREA bill, however, did something extraordinary for Wall. It appointed him as head of the successor agency (the Office of Thrift Supervision (OTS)) without the advice and consent of the Senate. Bush was warned in advance that this act could be held to be unconstitutional. The Senate Banking Committee was delighted not to hold hearings. Its chairman and ranking Democrat were members of the Keating Five and the ranking Republican, Garn, was co-sponsor of the Garn-St Germain Act of 1982 (the key deregulation bill) and Wall’s great patron. Senate confirmation hearings would have been intensely embarrassing to the new Bush administration, Wall, and the Senate Banking committee’s most powerful members.

FIRREA became law, Wall was appointed head of OTS by statute without the Senate’s advice and consent, and a federal court declared Wall’s appointment unconstitutional. The key development, however, was that Henry B. Gonzalez became Chairman of the House Financial Services Committee and began holding hearings on Wall’s regulatory failures at Lincoln Savings. Gonzalez’ actions were brave. Four of the five members of the Keating Five were Democrats. Many of Gonzalez’ Democratic senior colleagues were enraged that Gonzalez would hold hearings that were certain to embarrass the Keating Five.

Gonzalez’ series of hearings led to our powerful testimony explaining in detail Wall’s refusal to take action against Keating. Wall used the enforcement director as his attack dog to respond by attacking the FHLBSF and Gray – and to claim that Keating was the victim. Bush eventually responded by indicating that he no longer had confidence in Wall and Wall was forced to resign. His resignation was reported on December 5, 1989. Bush nominated Timothy Ryan to head the OTS and gave him a simple mandate – find the most prominent S&L frauds and take them down in the most public fashion to show that there was a new sheriff in town.

Our testimony also led to the resignation of the agency’s top supervisor, Mr. Dochow, who returned to a relatively low level supervisory position in our most obscure office – Seattle. Dochow was notorious because of his support for Wall’s cowardly caving in to Keating’s political pressure.

Ryan came into office shortly after we had provided a graphic example of how effective regulation could be. Pinnacle West, MeraBank’s holding company, had signed a net worth maintenance agreement as a condition of acquiring MeraBank. MeraBank was deeply insolvent, which meant that Pinnacle West was on the hook for many hundreds of millions of dollars. Pinnacle West’s lawyers came up with a clever means of evading the net worth maintenance agreement. They would dividend to their shareholders Pinnacle West’s ownership of MeraBank. The net worth maintenance agreement only obligated entities that “controlled” MeraBank to maintain MeraBank’s net worth, and because Pinnacle West’s shareholders were diverse there would be no one remaining (after the dividend) who owned a controlling interest in MeraBank.

There were only three problems to the clever scheme. First, there was a mechanical problem. As part of the deal in which Pinnacle West acquired 100% of MeraBank, the parties agreed that MeraBank would issue a single share certificate representing that 100% ownership to Pinnacle West. Pinnacle West’s lawyers thought they had a straight forward answer to the mechanical problem – MeraBank would issue hundreds of thousands of individual share certificates to Pinnacle West and Pinnacle West would dividend them to its shareholders.

That lawyerly solution to the mechanical problem, however, ran into the second and third problems. The second problem was the FHLBSF. After he removed the FHLBSF’s jurisdiction over Lincoln Savings, Wall’s effort to cover up its insolvency and frauds were blown up by courageous examiners from the California Department of Savings and Loan and several other Federal Home Loan Banks (special kudos to the FHLB Chicago staff). Wall realized that he was faced with a disaster on multiple dimensions and that he had to stop his jihad against the FHLBSF. That meant that he could no longer block us from taking vigorous regulatory actions, e.g., against Pinnacle West.

The third problem was that it would be a naked violation of their fiduciary duties for MeraBank’s board of directors to vote to issue additional shares. Pinnacle West’s primary asset was the net worth maintenance agreement. Voting to effectively remove that agreement would violate the duty of care. If the MeraBank directors who were also Pinnacle West officers voted to effectively destroy the net worth maintenance agreement that would violate the duty of loyalty (because of their crippling conflict of interest) and the duty of care. The FHLBSF’s senior staff flew to Arizona to address the MeraBank board of directors meeting to make this explicit to each director. In the trade in the U.S., this is known as a “come to Jesus” meeting. The MeraBank directors promptly decided that there was no way to issue the additional share certificates.

The FHLBSF then took the lead in negotiating an agreement that released Pinnacle West from its net worth maintenance agreement – in return for a $450 million payment. (Note: the enforceability of net worth maintenance agreements had never been litigated and our commercial ability to recover even if we were successful in establishing that enforceability was unclear. Pinnacle West, on a stand-alone basis, was insolvent. The net asset value of the holding company was tied up in its Arizona public utility and it was unlikely that the Arizona Public Utility Commission would approve a massive increase in electrical rates in order to provide funds to Pinnacle West so that Pinnacle West could pay the federal insurance fund a billion dollars. In sum, there were good litigation reasons for us to settle instead of suing.) Pinnacle agreed to the $450 million deal and OTS approved the settlement on December 7, 1989 (Pearl Harbor’s anniversary and the same day that President Bush announced his acceptance of Wall’s resignation.

The Pinnacle West deal confirmed Ryan’s view that OTS could accomplish great things if it were vigorous. He recruited Harris Weinstein, an accomplished, senior litigation partner at one of the nation’s most prestigious firms as his Chief Counsel. Among their first acts were to make clear that they supported fully the FHLBSF’s vigorous approach to regulation. (Most FHLB’s shared that same approach, but openly embracing us signaled that Wall’s jihad against the FHLBSF was over. Weinstein proved adept as a manger. He did not fire or criticize the enforcement director. He simply removed her monopoly over enforcement. OTS established three regional enforcement bodies headed by its most vigorous personnel and parallel enforcement bodies in Washington. The supervisors were permitted to use whichever enforcers they found most effective. The former litigation director left the agency for private practice.

The OTS took actions against the most elite control frauds on four fronts: regulation, civil actions, administrative enforcement actions, and support for criminal prosecutions. It closed the remaining frauds, virtually all of which had collapsed due to Gray’s rule restricting growth. (For a Ponzi scheme, growth is life.) More impressively, the West Region of OTS (staffed by supervisory personnel from the FHLBSF), killed through normal supervision the growing practice in Orange County, California of making “liar’s” loans and imprudent subprime loans. Michael Patriarca, personally recruited by Gray to crack down on the Western frauds, led the West Region’s crackdown. The effort was so successful that the leading nonprime S&L lender, Roland Arnall, gave up his federal charter (and federal deposit insurance) in order to escape our jurisdiction. Arnall created Ameriquest, a mortgage banker, to take advantage of a regulatory “black hole.” Arnall’s leading competitors also came from the S&L industry, e.g., the Jedinaks, who we “removed and prohibited” from the federally-insured financial industry through an enforcement action.

Ryan and Weinstein were exceptionally effective in prompting effective enforcement actions. In interpreting the magnitude of the increase in enforcement actions in 1990 over 1989 one must recall that the administration did not select Ryan until March 1990. Ryan then had to go through a bitterly contested Senate investigation and vote to secure appointment. Ryan’s selection of Weinstein became public on May 9, 1990. It, of course, took Weinstein months to create the parallel enforcement structure that I described and staff it.

In 1989, the agency issued 34 cease and desist (C&D) orders. In 1990, agency issued 63 C&Ds. In 1989, the agency issued 47 removal and prohibition (R&P) orders, in 1990 it issued 78. In 1990, the agency used its new grant of enforcement powers (via FIRREA) to issue 26 civil money penalties (CMPs). In 1989, the agency entered into 260 formal agreements, in 1990 that number rose to 347. The cliché “hit the ground running” applies to Ryan and Weinstein. In 1991, the agency completed 868 enforcement actions and in 1992 it completed 667 actions. Ryan announced his intent to resign on November 9, 1992.

In addition to the dramatic increase in the number of enforcement actions one must take into account that the actions brought under Ryan and Weinstein were far more major than the actions brought under Wall. Ryan and Weinstein went after the most elite, politically connected frauds to demonstrate that no one was above the law. The classic proof was the agency’s enforcement action against President Bush’s son, Neil. The enforcement action antagonized the Bush family. William Seidman’s (then, FDIC chair), book about his governmental service recounts how a senior White House staffer got the bright idea of convincing the FDIC to take over the case from the OTS so that the FDIC could kill the action. He called the FDIC’s general counsel to propose the idea. The general counsel, being a bear of very little brain, went to Seidman with the proposal. Seidman told him the idea was insane and not to get involved with it. The general counsel, being a bear with very little brain and soul, called the OTS to pitch the idea. Ryan made sure that the OTS filed an ethics complaint. The OTS went ahead and issued the enforcement order. (In truth, the order was a slap on the wrist – but royalty doesn’t think it should be slapped by peons.) From that day on, Ryan’s chances for advancement under President Bush were dead.

“But Mr. Ryan said that there were occasions when his decisions bore personal, as well as political, repercussions. He said some former political associates, whom he would not identify, had stopped talking to him after the Office of Thrift Supervision had decided to censure Neil Bush, the President’s son, for his role as a director of the Silverado Banking, Savings and Loan Association of Denver, one of the largest failures on record.

“Because of Neil Bush, I was persona non grata,” Mr. Ryan said. “At first I think it was because they did not want to influence me, and afterward I don’t know why they did not talk to me.””

The amazing aspect of the Bush administration’s response to the OTS enforcement action against Neil Bush is that it never became a scandal. In the current era, it would lead to an immediate demand for impeachment.

Weinstein made most of the legal community enraged when he brought an enforcement action against one of Keating’s primary law firms and “froze” its assets. “Froze” is an inaccurate description, but the one the bar used. Weinstein also moved to invoke the “fraud crime” exception to the ability to withhold the production of documents on the grounds of attorney client privilege. The law firm settled and its insurer made a major payout.

The agency’s and the Resolution Trust Corporation’s (RTC’s) civil suits were equally vigorous and effective. They produced billions of dollars in recoveries, often from what were then known as the “Big 8” audit firms. The lawsuits, of course, enraged the auditors.

On the criminal prosecution front, Ryan and Weinstein returned to Gray’s policy of making the support of criminal investigations and prosecutions a top agency priority. The agency met with the Department of Justice (DOJ) to create a formal prioritization of these cases – the “Top 100.” The dirty 100 were overwhelmingly S&Ls, as opposed to individuals, so this prioritization led to the prosecution of over 500 of the most elite and destructive criminals. The agency made well over 10,000 criminal referrals. Our criminal referral specialists liaised constantly with the FBI to get feedback on how to prepare the most useful referrals and trained our staff to produce superb referrals. (In modern management jargon, we really engaged in “continuous improvement.” Our criminal referrals were often 20 to 30 pages in length with two to three hundred pages of attachments. The referrals provided the detailed road map explaining the fraud and providing the key documents. The agency “detailed” a significant number of examiners to the FBI to serve as internal experts during the investigations (for the lawyers: this allowed them access to “6 (e)” grand jury materials). (The FHLBSF had pioneered an even more selfless approach – it paid the salary of an AUSA in Los Angeles dedicated to prosecuting S&L frauds. He did not, of course, answer to the FHLBSF.) Agency officials trained agency personnel, FBI agents, and AUSAs on detecting, investigating, and prosecuting elite financial frauds. We also served as free expert witnesses for the AUSAs in cases that came to trial. The results were spectacular. The conviction rate in S&L cases designated as “major” by DOJ was roughly 90 percent – against many of the top criminal defense lawyers in the world. We secured over 1000 felony convictions in “major” cases, and by prioritizing the “Top 100” we ensured that we acted against each of the worst frauds.

In 1993, the new Clinton administration moved DOJ resources to refocus on health care fraud. That may have been a correct prioritization of DOJ resources given out success against the worst S&L frauds, but it does mean that our 1000 convictions represents only a portion of fraud identified in our criminal referrals.

By the time Ryan and Weinstein left governmental service the S&L industry was cleansed of major frauds. The “liar’s” loans lenders had been driven out of the industry. The OTS criminal referral process was superb.

In the current crisis, President Bush (the Second) appointed “Chainsaw” Gilleran as OTS director – providing the crisis’ iconic image. Gilleran is holding a chain saw and standing next to the nation’s three leading bank lobbyists and the FDIC’s Vice-Chair, who are holding pruning shears. They are poised and posed over a pile of regulations. To make the imagery clear, the regulations are tied up in elaborate red tape. The image makes clear Gilleran’s and the FDIC’s intention to slash through all regulation. (Mission Accomplished!) Naturally, the anti-regulators were so proud of this image that they featured it the FDIC’s 2003 annual report.

The OTS leaders decided that the key to destroying regulation was to bring back to power the nation’s most notorious professional regulator – Dochow (of Keating infamy). Dochow rode Washington Mutual (WaMu) (based in Seattle) back to power. WaMu was a great “success” because it engaged in a variant of the accounting control fraud that made Keating infamous, but Dochow was not one to learn from his mistakes. The OTS leadership then used Dochow to convince Countrywide to convert its charter and become an S&L in order to avoid a potential enforcement by the somnolent Office of the Comptroller of the Currency (OCC). Dochow finally had to be asked to leave when he was caught agreeing to allow IndyMac (which, like WaMu, specialized in making “liar’s” loans) to backdate documents to inflate its financial “strength.”

So, how many criminal referrals did OTS make in current crisis? Zero – during what the FBI aptly described in September 2004 as an “epidemic” of mortgage fraud that the FBI aptly predicted would cause a financial “crisis” if it were not contained. Gray, Patriarca, Ryan, and Weinstein were all available to the second President Bush (and Obama) to use their expertise, integrity, and vigor to clean up the Stygian stables of the fraudulent and systemically dangerous institutions (SDIs) that drove this crisis. They are all available now, as are many of the people that helped these leaders clean up the industry. Patriarca and Ryan are young enough to serve as full time regulatory leaders. To my knowledge, the Bush II and Obama administrations have not drawn on the expertise of any of these leaders or their principal lieutenants who led the successful struggle against prior epidemics of accounting control fraud to implement an effective response to this crisis.

What would it take for the Geithners and Holders of the world to admit that allowing control fraud to occur with impunity is insane and that they should learn from people with a track record of success, integrity, and courage? Geithner, like “M.Danny Isuzu Wall,” is still pretending that he “resolved” the crisis at virtually no cost and kvetching that the world doesn’t applaud his genius. Like the Wizard of Oz, he demands that we: “ignore the man behind the screen,” i.e., the man holding the liar’s loans at Fannie and Freddie that will cause hundreds of billions of dollars of losses, the man at the Fed with hundreds of billions of dollars of losses on fraudulent mortgage paper pledged to Fed (which the Fed will eventually dump on Fannie and Freddie – which is to say, the Treasury), and the men holding the hundreds of billions of dollars of unrecognized losses among the SDIs. Geithner’s con has only fooled one person. Unfortunately, the man that fell for the Geithner con is President Obama, he of the infamous “man crush” for the admitted tax evader he appointed to be in charge of our nation’s tax collection.

One of our proudest moments at OTS (under Ryan and Weinstein) was issuing an R&P against Lee Henkel – one of the presidential appointees that ran our predecessor agency. President Reagan, at the behest of one of his leading contributors (Charles Keating), made Henkel a “recess” appointment to run the Federal Home Loan Bank Board. Henkel served as Keating’s “mole” at the agency. He resigned after I blew the whistle on him as part of a deal with the FBI to drop its criminal investigation of him. The OTS, however, made sure he would not come back to harm the public by issuing a removal and prohibition from federally insured depositories. If only Sheila Bair had possessed the nerve to remove and prohibit Geithner’s Treasury minions that he recruited from the fraudulent SDIs…. Sigh, one can dream.

By volume, Part 3 of my column has focused on enforcement, civil suits, and prosecutions. It is vital to keep in mind that these are after the fact remedies. It is vastly more important for financial regulators to understand accounting control fraud mechanisms and patterns so that they can identify and take regulatory action that will prevent the crisis. Patriarca’s actions to end liar’s loans in by Orange County S&Ls (taken while Ryan was Director) are a classic example of how successful a regulator can be when it understands the need to function as a “cop on the beat” and prevent the Gresham’s dynamics that drive fraud epidemics. The same actions show one of the important lessons of regulation. No one builds a bank vault and then puts an unguarded and unlocked hole in it, but our anti-regulators constantly seek to achieve the equivalent by creating financial regulatory systems that are designed to fail. The Fed had unique authority under HOEPA to close all of these regulatory black holes. Alan Greenspan and Ben Bernanke refused to do so. If Gray, Ryan, Patriarca, or Weinstein had been in charge there would have been no epidemic of mortgage fraud, no crisis at Fannie and Freddie, no overall financial crisis, and no Great Recession. (I’m not suggesting they had the power to end recessions and business cycles.)

We see the consequences of what happens when, during the last three administrations, we did not care to send the very best into the ranks of regulatory leadership. There were times during the Civil War in which thousands of men’s lives were thrown away because their senior officers were incompetent political hacks. Why do we routinely send incompetent political hacks and the equivalent of “flat earth” anti-regulatory ideologues to be our regulatory leaders and then blame “regulation” for the disaster? Even the Soviets figured out that one of the secrets of success was to “never reinforce failure.” We promote our failures and give them presidential medals. The high priests of theoclassical economics and their law and economics acolytes will always fail as regulators. They are trained to create and worship intensely criminogenic environments.

I do not know whether you, the reader, has focused on the politics of the leaders I have been praising. Gray and Ryan are Republicans. I worked for years with Patriarca and Weinstein and do not know their political affiliation. It never mattered to us. We despise the elite frauds and their professional and political toadies regardless of their party.